Risk Management Manual of Examination Policies - FDIC

SECURITIES AND DERIVATIVES Section 3.3
passive strategies, due to their higher transaction volume
and complex analysis.
An interest-rate expectations strategy is an attempt to
maximize return based on a forecast of future interest rate
movements. An example of this strategy consists of
adjusting the duration of a bond portfolio to take advantage
of expected changes in interest rates. The success of this
strategy depends on the accurate forecasting of future
interest rates.
An individual security selection strategy is an attempt to
identify individual instruments that will outperform other
similarly rated instruments. The most common of this type
of strategy identifies an issue as undervalued because its
yield is higher that that of comparably rated issues or its
yield is expected to decline because credit analysis
indicates the issue’s rating will change. The success of this
strategy depends on superior skill in performing credit
analysis. An active strategy assumes that the investor will
attempt to outperform the market.
Many other investment strategies may be employed without
measuring risk on a portfolio basis. Two commonly used
active strategies include yield curve strategies and yield
spread strategies.
Yield curve strategies involve the positioning of fixedincome
portfolios to capitalize on or protect against
expected changes in the shape of the Treasury yield curve.
These strategies may be referred to as “riding the yield
curve.” Three common yield curve strategies are bullet
strategies, ladder strategies, and barbell strategies.
A bullet portfolio is constructed so that the maturity of the
securities is highly concentrated at one point on the yield
curve. A laddered portfolio spreads instruments (and
reinvestment risk) across the maturity spectrum and
provides regular cash flows. A typical laddered portfolio is
constructed with approximately equal percentages of the
portfolio maturing at different segments of the yield curve.
A barbell portfolio concentrates instruments at the short
term and long term extremes of the maturity spectrum.
Barbell strategies can be used to take advantage of, or
compensate for, non-parallel shifts in the yield curve.
These strategies are based on the theory that the value of
long-term bonds will appreciate more when long-term
market interest rates fall, than shorter-term bonds
depreciate even if short-term market interest rates
simultaneously rise (a non-parallel yield curve shift). The
ability to reinvest the proceeds from maturing short-term
bonds at higher short-term rates provides this value. The
actual performance of a barbell strategy will depend upon
both the type of non-parallel shift (e.g. steepening or
flattening) and the magnitude of the shift. For example,
barbell strategies will be disadvantageous if long-term
market interest rates rise while short-term rates remain
unchanged.
Yield spread 3 strategies involve the positioning of fixedincome
portfolios to profit on expected changes in yield
spreads between sectors of the bond market. These sectors
can vary by type of issuer (such as Treasury, agencies,
corporates, and mortgage-backed securities), quality or
credit (such as Treasuries, triple A, double A), coupon
(such as high-coupon/premium bonds, low
coupon/discount bonds), and maturity (such as short,
intermediate, or long term). Spreads can change for a
variety of reasons. For example, the spread between top
quality and lower quality bonds tends to narrow as business
conditions improve, and widen when business conditions
deteriorate. Making changes in the portfolio to take
advantage of changes in spreads will often result in
accepting additional credit risk or extension risk.
Cash flow matching strategies attempt to match the cash
flow requirements of a bank’s liabilities with the cash
flows provided by specific investments. This approach is
also known as dedicating a portfolio. Bonds are selected
with maturities, principal amounts and coupon payments
that match the bank’s liability payment stream.
Theoretically, this cash flow matching process can be
continued until all liabilities have been matched by the
cash flows from securities in the portfolio. Interest rate
risk reduction is the primary advantage of this strategy,
since a known amount of cash sufficient to fund the
required payment schedule will be generated with
certainty. The inability to reposition the securities being
used to match liabilities, the possibility of bonds being
called, and the possibility of bonds going into default are
the primary disadvantages of this strategy. Cash flow
matching strategies are becoming more popular in banks
that use FHLB borrowings.
Using total return measurement in determining an
investment strategy better incorporates the investor’s
interest rate expectations over time than either a simple
yield to maturity or yield to call investment selection. The
total return for an individual bond consists of the change in
the market value over the measurement period; the coupon
received; and the reinvestment interest on the cash flows
received during the measurement period. For bond
portfolios, the total return is the weighted average of the
3 Yield spread is the yield premium of one bond over
another. Traditional analysis of the yield premium for a
non-U.S. Treasury bond involves calculating the difference
between the yield-to-maturity of the bond in question and
the yield-to-maturity of a U.S. Treasury security with a
comparable maturity.
DSC Risk Management Manual of Examination Policies 3.3-20 Securities and Derivatives (12-04)
Federal Deposit Insurance Corporation